Inflation Negatively Impacts Effective Tax Rate on Capital Gains

Under the federal tax code, inflation can create an infinite effective tax rate on capital gains, and in fact, if a taxpayer purchased an average stock in 2000 or 2007 and sold in 2013, he or she would be taxed entirely on inflation, according to a new study from the Tax Foundation, a not-for-profit, nonpartisan tax research organization based in Washington, DC.

Instead of taxing individuals on inflation, the authors of the study recommended inflation indexing, which would link the capital gains tax to real increases in income instead of increases in inflation.

“Any capital gain due to inflation is not accounted for, and the taxpayer is taxed on both increase in income and on increases in prices economy-wide,” Aldridge and Pomerleau noted in the study. “As a result, the effective tax rate on the real (inflation indexed) capital gain has exceeded the statutory rate every year since 1950 and has averaged around 42 percent,” which is nearly twice the statutory rate.

The effective rate on real gains varied between 26.4 percent for a stock purchased in 1950 and 309 percent for stocks purchased in 1998, according to the study. For stocks purchased in 1999, 2000, and 2007, the nominal price of the stock increased, while the real value declined. As a result, the authors noted, “the effective rate is infinite.”

Aldridge and Pomerleau added that the tax paid on inflation as a percent of a taxpayer’s total tax bill is relatively small if the stock were bought in the 1950s or in the 1980s because of the real increase in the value of the market since those decades.

“In contrast, the average stock bought in 1999, 2000, or 2007 would yield real losses if sold in 2013 but nominal gains on the order of 19.6, 12.1, and 7.7 percent, respectively,” they wrote. “The capital gains tax owed on the average stock bought during these years is solely due to inflation.”

The most obvious, yet likely politically inexpedient, option to stop the practice of taxing individuals on inflation would be to eliminate the capital gains tax, the study stated.

Repealing the capital gains tax would be a “pro-growth change and produce positive long-term dynamic effects for the economy,” Aldridge and Pomerleau wrote. “A decrease in the cost of capital would increase the amount of capital available for investment, improving the productivity of business and raising average wages.”

A second possible solution, Pomerleau said, is inflation indexing. While keeping the current tax on capital gains in place, taxpayers could be able to index the basis of their gain to inflation.

“In order to index the long-term capital gains tax, applicable inflation ratios stretching back several years would need to be determined annually,” so taxpayers could adjust the basis, or purchase price, of the asset in order to tabulate their real capital gain, the researchers noted in the report.

“This would not be so different from the inflation factor the IRS determines annually for calculating the increase in brackets, thresholds, and deductions for the personal income tax,” Aldridge and Pomerleau wrote.

Capital gains have historically received a preferential rate over ordinary income, and the authors noted there has been some discussion that this lower rate exists to account for the lack of inflation indexing.

“This argument is not logically consistent since some taxpayers still end up being taxed on real losses, and the average effective rate on capital gains of 42.5 percent is higher than the top personal income tax rate of 39.6 percent,” they wrote. “The motives behind lower rates on capital gains are separate from the impact of inflation on the tax. Indexing would address the current disconnect between the tax levied and whether the taxpayer actually made a profit or loss.”

Ultimately, Aldridge and Pomerleau concluded this possible alteration to the tax code would make the code more complex.

“There is already an excess of rules with regard to determining the correct basis and sales price, in addition to the types of assets and transactions to which the tax applies,” they wrote. “The additional inflation adjustment would complicate the code even further. Inflation indexing would also accentuate the periodic nature of the revenues from this tax, which results from the business cycle, since there would be far fewer real capital gains than nominal capital gains during a recessionary period.”